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The Skinny on Subprime

Buffett on the beachDuring the early days of Berkshire Hathaway (NYSE: BRK-A) (NYSE: BRK-B) , Warren Buffett would spend the beginning of the year at his California beach house writing his annual letter to shareholders. Over the years, these annual letters have become gospel in the investing field. The ocean breeze must bring something to life for the Oracle.

It know it does for me. Every year, I, too, like to take a little hiatus to the beach to read, write, and kayak among the dolphins. It all helps me clearly articulate my investment ideas. For the past four years, my destination has been St. George Island, located along the Florida panhandle on the Gulf of Mexico. It's a tiny island, with only one hotel, some beach homes, and a state park.

For years, nobody really thought much of St. George -- the area is dubbed "the Forgotten Coast" -- but the island began to get really popular about 10 years ago, and property development took off about five years ago. But as I was driving into the island this year, just about every other property had a "For Sale" sign planted on it. It was the same on the island -- beach houses for sale everywhere in sight. After calling a few real estate agents, I found that the financing tool of choice over the past few years has been the commonly misunderstood adjustable-rate mortgage, which has been widely marketed in the subprime-lending market. With the recent buzz in the media about a possible subprime meltdown, I thought it was time to consider this issue in more detail.

The basicsOur capital markets operate on the basic premise of risk versus reward. Investors taking a risk on stocks expect a higher rate of return than do investors in risk-free Treasury bills, which are backed by the full faith and credit of the United States. The same goes for loans. Less creditworthy subprime borrowers represent a riskier investment, so lenders will charge them a higher interest rate than they would charge a prime borrower for the same loan.

To avoid the initial hit of higher mortgage payments, most subprime borrowers take out adjustable-rate mortgages that give them a very low initial interest rate of around 4%. But with annual adjustments of 2% or more per year, these loans typically end up charging around 10%. So a $500,000 loan at a 4% interest rate for 30 years equates to a payment of about $2,400 a month. But the same loan at 10% for 27 years (after the adjustable period ends) equates to a payment of $4,470. A 6-percentage-point increase in the rate caused an almost 100% increase in the payment. Ouch!

Fuel to the fireWhenever there is an opportunity to make money, an excess of players wanting a piece of the action usually follows. In the case of subprime lending, Wall Street was all too happy to provide tons of cash to lenders. Why? Basically, a subprime lender packages its loans into financial instruments, through a process known as securitization, and Wall Street buys the loans for 102 cents on the dollar, in order to earn 104 cents on the dollar. Repeat this process over and over, and you begin to see how quickly a lot of money can be made.

As subprime lenders became flush with cash, new loans needed to be made to keep the profit spigot running. But with more and more money available to lend out, the quality of borrowers began to deteriorate. The lure of low initial interest rates, combined with an abundant supply of cash, meant bigger and bigger loans without any regard to income levels. And all of a sudden, a family who makes half the income of their neighbor was living in a home twice as expensive as their neighbor's. The neighbor, not to be outdone, would then buy an even bigger house.

If housing demand remained strong -- as it did during the housing-market boom -- everyone was happy. You never worried about a rising mortgage payment, because you could easily sell your house quickly and profitability. Subprime lenders, meanwhile, experienced artificially low default rates relative to borrowers' creditworthiness. This operating environment allowed the likes of Accredited Home Lenders Holding (Nasdaq: LEND) , Fremont General (NYSE: FMT) , and New Century Financial to become the darlings of the day. Accredited shot up from just below $10 a share in 2003 to more than $50 a share in 2006.

Today, New Century is bankrupt, and investors in Accredited during its peak in 2006 watched painfully as the stock slid to less than $5. It's recovered to only about $15 today. As housing prices started to tank, borrowers who previously had no trouble selling their properties now found themselves unable to sell as their mortgage payments began to rise. Even worse, property values have now declined to such an extent that a sale wouldn't even cover the loan balance. The recent blow-ups at Bear Sterns' (NYSE: BSC) hedge funds are a case in point.

As Buffett aptly said, "Price is what you pay; value is what you get." Just like a stock, property is undervalued at one price, fairly valued at another price, and overvalued at yet another. The goal is to buy the first, avoid the second, and sell the third. Maintain this discipline all the time, and you will never have to worry about what cycle of the market you're in.

The Forgotten CoastThe waves at St. George Island aren't the only things crashing on the shore. I have found a couple of ready-to-build lots selling for more than entire beach houses a couple of houses down. In effect, you're getting the beach house for free. I haven't looked into great detail at the price discrepancy, but from the looks of it, some owners got caught at the top of the cycle and are now struggling to make ends meet. They simply paid too much using high-cost capital. The end result is not unlike that of the investor who gets hit with a margin call after giddily buying stocks on margin. Those waves can come crashing in hard.

Fool contributor Sham Gad runs the Gad Partners Fund, a value-oriented investment partnership similar to the 1950s Buffett Partnerships. He owns shares of Berkshire Hathaway. You can reach him at shammf@gmail.com. The Fool has a crystal-clear disclosure policy.

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